Why The IRS Went After Coinbase

Coinbase, the cryptocurrency trading platform, has been ordered[1] by a federal court to turn over information sought by the IRS relating to more than 14,000 of the site's users. As TechCrunch puts it, the IRS noticed "the number of tax returns claiming gains from virtual currency didn't line up with the emerging popularity of digital currencies like bitcoin as an investment vehicle."

This may be a gross understatement, considering fewer than 1000 US taxpayers reported gains on cryptos to the IRS in recent years. If this statistic[2] is believable, 2% of Americans-- 6 million people-- owned bitcoin way back in 2014. Surely the number must be much higher today. Either they're all buying and holding, or they're not informing Uncle Sam about it. And of course this was one of the great promises of the crypto revolution, perhaps the greatest promise: the ability to transact business away from the prying (and taxing) grasp of governments.

In 2014 the IRS attempted to throw cold water on the party, announcing[3] it would tax cryptocurrencies as "property" (i.e. like stocks or real estate) rather than currency. Bitcoin henceforth would be treated as an investment generating capital gains or losses for most taxpayers.

The effect of this rule would be disastrous for the evolution of cryptos into actual widely-used currencies: taxpayers would need to track[4] the tax basis of their bitcoin just like stocks, but more importantly would have to treat every purchase of a sandwich at Starbucks as a taxable event--i.e. a "sale" of property. Netting out annual gains and losses and tracking every purchase made with cryptos might be a boon to tax preparers, but it's a serious blow for a technology aimed at creating private money.

So far the IRS guidance hasn't mattered much to crypto fans, who in fact buy bitcoin primarily as an investment rather than a currency exchange. And the bigger question of whether the IRS can effectively enforce its rule remains unanswered. But a few newsworthy criminal prosecutions of large bitcoin users who fail to report their activity to the IRS could have a quick chilling effect. At the very least smaller users might get very nervous about using platforms like Coinbase rather than private wallets.

Governments hate privacy, hence the war on cash[5] and their rabid preoccupation[6] with foreign bank accounts. Politicians know they don't like bitcoin, but they haven't figured out what to do about it. In fact, Congress has passed no legislation* specifically addressing cryptocurrencies-- all action has been taken unilaterally by administrative agencies (in particular the IRS and SEC). As a result cryptos have enjoyed a honeymoon period, much like Uber in its early days. Whether this happy interlude can last may depend on whether opponents can frame bitcoin as a sinister tax dodge for drug dealer and the 1% tech cognoscenti.

Cryptocurrencies can fulfill their great promise only if they become truly private money: unregulated, untaxed, un-banked, untraceable, and 100% peer-to-peer. In the meantime, the Feds may treat big bitcoin users like Al Capone and go after them for tax evasion.

*Legislation[7] has been introduced, though it's a long way from passing, that would validate the legality of cryptocurrencies. The potential Trojan Horse, however, is a set of anti- money laundering and drug trafficking provisions.